Ares Capital Stock: Our top pick for rising interest rates

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Ares Capital Corp. (NASDAQ: ARCC) is one of the largest investment-grade BDCs with a superior balance sheet and an attractive dividend yield of 8.4%. The company crushed the S&P 500 (SPY) on during its public existence and today offers investors an attractive combination of high current yield and dividend growth as well as resistance to rising interest rates.

ARCC Stock Chart
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While the stock sold off strongly following its first quarter results, we are optimistic about the stock’s performance for the following reasons:

#1. The growth of the NAV of Ares Capital continues

Despite an environment in which ARCC’s equity holdings are likely impacted by market volatility, ARCC has still managed to generate growth in net asset value per share. Net asset value per share reached $19.03, up 0.4% sequentially and 9% year-on-year. Combined with the payment of substantial dividends over the past year, ARCC’s shareholder wealth creation has been – and continues to be – impressive.

Basic earnings per share of $0.42 fell a penny year over year, but still covered the dividend of $0.42.

#2. ARCC – Strong Balance Sheet and Portfolio Performance/Positioning

While not as impressive as Oaktree Specialty Lending (OCSL) metrics, ARCC’s debt-to-equity ratio of 1.13x was quite solid, especially given the breadth and diversification of his investment portfolio. Moreover, it represents a marked improvement from the 1.26x level seen at the end of the fourth quarter. ARCC also has huge liquidity of nearly $5.9 billion, including free cash of $690 million.

At the same time, the cost non-recognition rate of 1.2% is well below the ARCC’s 10-year average of 2.5% and is also well below industry averages, reflecting very good underwriting practices and a portfolio well positioned to weather an economic downturn.

Last, but not least, the CEO emphasized on the earnings call that the ARCC remains well positioned to weather rising interest rates, saying:

we do not believe that a cycle of monetary tightening will have negative effects on us. Our large floating rate loan portfolio is funded primarily by fixed rate unsecured funding sources and our assets are largely floating rate investments. We believe this puts us in a good position for our net interest income to benefit from rising rates. At the end of the quarter, all things being equal and after taking into account the impact of revenue-based expenses, we calculated that a 100 basis point increase in short-term rates could increase our annual earnings by approximately $0.23 per share, an increase of 14% over this quarter’s base EPS run rate.

A 200 basis point increase in short-term rates could increase our total annual earnings by approximately $0.44 per share, a 26% increase over this quarter’s base EPS run rate.

We also don’t expect a projected rate hike to cause credit performance to deteriorate, especially given our strong starting point with a portfolio weighted average interest coverage of nearly 3x. This means that, all things being equal, including borrower-level leverage, short-term base rates would need to rise above 3% before aggregate interest coverage falls below 2x, which is similar to the 5-year pre-borrower period. pandemic weighted average of 2.3 times.

It is important to note that this analysis does not take into account the EBITDA growth or deleveraging that often occurs in our portfolio. We are pleased with the ability of our portfolio companies to navigate a higher rate environment and believe this dynamic will further differentiate Ares Capital from most other income-focused alternatives in the market today.

#3. Safe and attractive ARCC dividend

Finally, ARCC’s dividend remains safe and attractive. Even though core EPS barely covered the quarterly dividend in the first quarter, several factors also need to be considered, making the current dividend yield of 8.4% much safer than the tight hedging would imply. .

First of all, ARCC has a very strong investment grade balance sheet with plenty of cash, as mentioned before.

Second, its portfolio is doing well and ARCC has a track record of successful underwriting through economic cycles.

Third, the ARCC expects rising interest rates to serve as a powerful catalyst for earnings per share.

Last, but not least, he still has some undistributed taxable income. As the CEO pointed out during the earnings call:

I mean our undistributed taxable income and our dividends. We currently estimate that our overhead revenue from 2021 to 2022 will be approximately $651 million or $1.32 per share. We believe that having strong and meaningful retained earnings supports our goal of maintaining a stable dividend through market cycles and sets us apart from many other BDCs that do not have this level of earnings.

Key takeaway for investors

ARCC remains a top-notch BDC with fundamentals that imply consistent and growing dividends per share and steady capital appreciation are likely underway in the years to come.

Furthermore, the ARCC is particularly well positioned to benefit from rising interest rates and the strong performance of its portfolio means that it is in fairly good shape in the event of an economic downturn.

Accordingly, we believe that the latest decline in the share price presents an attractive opportunity to potentially add to our position, which we could do in the near future:

Ares Capital share price
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Sallie R. Loera